<THE BORING PORTFOLIO>
Waiting for Berkshire's Q1
And a Pre-Sell Notice
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (May 14, 1999) -- I was hoping to discuss Berkshire's quarterly report, which is to be published today, but it looks like I'm not going to get my eyes on a copy of it before deadline. I'll talk a little bit about Berkshire later. But first I'd like to offer up a post I wrote in reply to a valuation of Triarc Companies (NYSE: TRY), titled "Why Triarc is Worth Twice its Price" published earlier today on Yahoo! I think the problem is a good one for investors who are beginning to delve more deeply into figuring out the value of a company. So you'll have to read the piece hyperlinked above and then read my reply below to get the gist of it:
Assuming those are good private market values for Triarc -- and I don't disagree since I don't follow the company -- the analysis of firm value to sales doesn't take into account the company's debt. Not all the sales and pre-tax earnings those sales generate go to holders of common. If you do a firm value to sales comparison, you can't just blow off the company's net debt position.
The valuation put the firm value at $1.3447 billion, if I read it correctly. From that firm value, you would deduct net debt to arrive at a fair equity value. Components of net debt are:
Long-term debt: $698.981 million
Current portion of LT debt: $9.98 million
Accrued interest and short positions, found in accrued expenses: $46.9 million
Less distributable cash, equal to cash and marketable securities less cash equal to 6% of revenues (one can adjust this according to what one feels is prudent): $212.1 million (which is $260.98 million less $48.9 million -- error due to rounding).
So net debt is $755.86 million less $212.1 million, or $543.76 million.
Deducting that from your calculation of a fair value for the firm, a fair value for the equity is $800.94 million. At a sharecount of 31.5 million shares, fair value for the equity is $25.43 per share.
So there may be excess value in the common, but nowhere near as much as the valuation indicates, using a static approach of putting comparable multiples on revenues. All I'm saying there is that the company may be worth more, but I see ignoring debt as a critical flaw in the valuation of Triarc.
Just to illustrate the point a little further, suppose you had a company with $20 billion in sales. In the first case, the company has 400 million shares outstanding priced in the market at $40 apiece and it has $4 billion in net debt. That would put the company's enterprise value to sales at 1x sales and put the equity value to sales at 0.80x. In the second case, the company has 200 million shares outstanding at $40 per share and $12 billion in debt. That again would put the company's enterprise value to sales at 1x and its equity value to sales at 0.40x.
If we tried to compare the equity value in the second case and say it should sell at 0.75 times sales, then we'd put the market price at $80. Forgetting the tax shield or the high risk premium that CAPM adherents would ascribe to the equity in discounting equity, you wouldn't have a market value of $16 billion plus $12 billion in debt for an enterprise value of $28 billion. In both cases, the capitalized equity value plus debt less excess cash is the enterprise value. When capitalizing a gross figure like sales, net profits after tax, or assets, you have to look at the enterprise value and not just the equity value. Even with a little tweaking to the Miller-Modligliani equivalence that is a bedrock of finance, that's a solid concept that really shouldn't be forgotten.
* * *
With Berkshire Hathaway (NYSE: BRK.A) reporting today, for those who are new to the company, I'd like to point out some of the problems in analysis in a recent Mutual Funds online article about Berkshire. The first problem is the title: "Warren Buffett's Fabulous Fund." Old hands at Berkshire know the problem with it. It's really not a fund, virtual or not. The way I calculate invested capital, which is total assets less noninterest-bearing current liabilities (not including reserves) less 70% of the deferred tax liabilities, only 30% of invested capital is represented by marketable equity investments.
The article disagrees: "But when you consider the price of Berkshire Hathaway stock, things get even more dicey: Essentially, acquiring Gillette by buying Berkshire stock is like paying 100 times earnings. Why? Because the market has accorded Berkshire a price that values it far beyond the combined values of its individual stock positions." Kyle Tomlin of the Wisdom Fund also disagrees: "We figure Berkshire Hathaway is priced at a substantial premium- -- 60 to 70 percent, or more -- above the actual net asset value of its holdings."
I don't have any idea of how the Wisdom Fund is calculating that, but I follow the company pretty closely and I just can't get the following pro-forma operating numbers (which are mine and not published by the company -- therefore I may miss some small intra-company consolidations) through Q3 1998 off my mind when I try to asses the company's intrinsic value:
(numbers in millions of dollars)
Insurance premiums earned.....$11,526.10
Sales and service revenues.....$4,234.50
Interest, dividends, and other investment income.....$2,732.30
Income from finance business.....$43.80
Realised investment gain.....$3,371.30
Total revenues.....$21,908.00
Revenues ex. realized investment gain:.....$18,536.70
Costs and expenses
Insurance losses and loss adjustment expenses.....$8,077.10
Insurance underwriting expenses.....$2,476.60
Cost of products and services sold.....$2,684.90
Selling, general, and administrative expenses.....$1,801.80
Goodwill amortization.....$121.10
Interest expense.....$109.90
Total.....$15,271.40
Income before income taxes and minority interests.....$6,636.60
Income before income taxes, minority interests, realized gain, and goodwill amortization.....$3,386.40
Net income ex gains+ goodwill amortization.....$2,198.94
EPS on above.....$1,454.64
I don't look at the company, personally, as a bunch of stock holdings and as separate businesses just as I wouldn't look at Allstate or Chubb as bond mutual funds. Insurance underwriters carry large portfolios of securities and that's just a fact of the business. The company's going to invest wherever it can maximize return on marginal invested capital, whether that's in raising a patented breed of jackass or in taking big stakes of publicly-traded companies.
To draw a parallel between a fund and Berkshire is totally missing the point. If I wanted to point to Coca-Cola's concentrate manufacturing plants and ascribe all the value of the company to those plants, I could say the company's trading at a big premium to its plant assets. You can't just take those assets away from the Coca-Cola trademark and worldwide distribution system and say, "Yeah, this is overvalued." And even if one wanted to do a competent breakup analysis of Berkshire, which I don't consider the Widsom Fund's analysis to be, you would have to asses the going-concern value of the wholly-owned subsidiaries, the excess uninvested capital that reduces one's purchase price of the company, and as well as the $20 billion+ portfolio of fixed income securities.
In any case, the company is worth more alive than it is dead, so a breakup analysis is somewhat pointless. These holdings all feed into one company that can beat its cost of capital by varying degrees -- in some year large, in other years not so large, over the long run. With excellent underwriting operations, a bunch of cash-generating businesses in the fold, many billions of dollars of excess capital and capital that could be converted to equities (wholly-owned or publicly-traded), almost no premium to invested capital at the moment, and tons of talented individuals at the company, not the least of which is a super-genius at the helm, I don't know why some professional investors have such trouble with thinking about this company correctly.
* * *
I'll wrap up today with some thoughts on Cisco Systems (Nasdaq: CSCO), and I'll open any of these issues to discussion on the Boring message board. I've been thinking of selling part or all of our position in Cisco. I understand what they do and what their potential is, but I feel I have zero competitive advantage in looking at this company. In fact, I'm at a severe disadvantage to tens of thousands of people who work in the industry, who manage money, or who just know about data communications and telecom equipment avocationally. As I've said before, doing the numbers is not a big deal. Yes, it has big margins and yes, I think it's a superbly managed company. But I can't tell you anything about the competitive threat that Juniper or any other hotshot startup represents to Cisco. I know there's a coming tornado in the merger of circuit and packet switching, but I can't tell you who's who and what's what.
Just because Cisco has a gorilla position in certain elements of datacomm doesn't mean it will last forever. It could, I'm not saying that. But I have no idea. With the company representing 35% of the portfolio through our holding the position since taking over the portfolio in October of last year, I could thin it down. But what's the difference in owning 1% of something you don't know well and owning 35%? I'd rather be an owner of things I know well and have confidence in them when they make up more than a third of the portfolio. With the benefit of the tax assets that we've taken advantage of and a low long-term capital gains tax rate, the tax bit here doesn't worry me too much.
To the best of my limited ability in valuing this company, we're selling it below its intrinsic value of $140 per share, and that does kind of bother me. But not knowing this company well at all and without the prospect of learning it well enough to gain some sort of competitive advantage in analyzing it bothers me even more. We will very likely put out a sell notice on it next week.
By the way, if you haven't seen it, our special series on the latest installment of the Star Wars trilogy is a great read. There's some great work in there and I commend my fellow Fools on it. Also, speaking of special series, before it disappears into the ether, check out the interview Yi-Hsin Chang and I did with Robert Hagstrom, author of The Warren Buffett Portfolio and manager of Legg Mason Focus Trust, a few weeks back.
Have a good weekend and go Sabres.
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